Ohlson O-score

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21 Aug, 2024

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The Ohlson O-score is a financial model that aids in assessing the possibility of a company facing financial distress or bankruptcy. It comprises nine financial ratios assigned specific weights and combined to produce a single score. It aims to evaluate the creditworthiness and risk associated with a company's financial standing.

The Ohlson o-score model utilizes information from a company's financial statements, including profitability, liquidity, leverage, and operating efficiency, to evaluate its financial health. A high score indicates a higher chance of facing bankruptcy, while a low score suggests a lower possibility. It has high accuracy in forecasting financial distress.

What Is Ohlson O-score?

The Ohlson O-score is a financial tool that helps forecast a company's financial distress and bankruptcy threats. It was formulated in 1980 and named after its creator, James Ohlson.
The model uses nine factors related to the company's financial ratios and assigns each a specific weight based on its impact on the financial risk possibility. Two factors are dummies as they have zero effect, and their values are usually 0.
The score calculation combines the nine factors with the co-efficient weighted financial ratios.

Ohlson O-score Explained

The Ohlson O-score was created in 1980 by James Ohlson. It is a financial formula that attempts to predict the possibility of a company facing financial distress or bankruptcy within the next two years. Investors, analysts, and lenders widely use the Ohlson o-score model to assess a company's creditworthiness and financial health.

The score calculation uses nine financial ratio factors. Each ratio has a specific weight based on its relative importance in predicting financial distress. These variables include profitability ratios, liquidity ratios, leverage ratios, and other measures. Two factors are dummies because they do not impact the formula. As a result, their values are 0.

The O-score formula combines the nine factors by multiplying them with their respective weights and adding them up. The resulting score is a numerical value that reflects the company's overall financial health and distress risk.

How To Calculate?

The Ohlson O-score formula can calculate the score:

Where,

TA = total assets
GNP = gross national product price index level
TL = total liabilities
WC = working capital
CL = current liabilities
CA = current assets
X = 1 if TL > TA, otherwise 0
NI = net income
FFO = funds from operations
Y = 1 if a net loss for the last two years, otherwise 0

Example

Let us study the following example to understand this score:

Thailand has historically functioned on a system with personal trust between parties where oral contracts are common. Bankruptcy leads to a decline in faith and eventually hinders the country's prosperity. There have been many bankruptcy studies in Asia. One of the primary methods the West uses to predict bankruptcy is Ohlson's O-score.

In 2004, Pongsatat examined Ohlson's Logit model for predicting bankruptcy in Thailand. This study expands on Pongsatat's 2004 study examining Ohlson's Logit model's ability to forecast default for financial and non-financial companies. This is an example of Ohlson's O-score.

Applications

Some Ohlson O-score applications are:

Lenders and financial institutions use the score to evaluate the creditworthiness of potential borrowers. Using this model, lenders can assess the possibility of bankruptcy and default threats. It assists them in making informed decisions about extending credit or loans.
Investors and analysts utilize this score to assess the companies' financial health and distress risk. They compare the scores of different companies within an industry. Investors can identify potential investment opportunities or potential risks associated with certain companies.
Asset managers use this score as a financial instrument in their portfolio management strategies. The managers can assess the risk profile in their portfolio by incorporating the score into their decision-making process. It enables them to make adjustments according to their specific needs and objectives.
The model can be an early warning system for potential financial distress or bankruptcy. Stakeholders can identify deteriorating economic conditions by tracking the company's score changes over time. This allows them to detect potential threats and take corrective actions to mitigate risks.
The score is a screening instrument for assessing investment opportunities. Investors can set specific score limits to filter out companies with higher financial distress risks. It can help them detect companies with strong financial positions.
The model can be a beneficial instrument for the mergers and acquisitions processes. It helps acquirers evaluate the financial health and stability of target companies. The scores aid in making more informed decisions about potential deals.
Risk management professionals utilize the score as part of their risk assessment systems. By incorporating the score into risk models, they can quantify and manage the financial distress risk associated with various investments.

Ohlson O-score vs Altman Z-score

The differences are as follows:

Ohlson O-score: James Ohlson developed this financial model to assess a company's possibility of facing financial distress or bankruptcy. It combines nine financial ratios and accounting variables to calculate a single score that reflects a company's financial health. Investors, analysts, and lenders commonly use the O-score to evaluate a business's creditworthiness and make informed investment decisions. It provides a quantitative measure for distress risk, where a higher score indicates a higher chance of encountering financial distress.
Altman Z-score: This is a popular financial model created by Edward Altman to predict the probability of corporate bankruptcy. It uses a combination of five financial ratios related to profitability, liquidity, leverage, solvency, and efficiency. The Z-score is calculated by assigning specific weights to each ratio and then summing them up. A higher score indicates a lower bankruptcy risk, while a lower score suggests a higher risk. Investors, analysts, and lenders widely use this score to assess companies' financial health and bankruptcy risk. It is a valuable tool for evaluating credit risk, making investment decisions, and tracking a company's financial stability.

Frequently Asked Questions (FAQs)

1. What are the limitations of the Ohlson O-Score?

Although the model is efficient in predicting bankruptcy, it has some limitations. They are as follows:
- It relies on historical financial data.
- The model assumes linear relationships between variables.
- This model may contain inaccuracies due to variations in accounting practices.
- The model may not capture sudden changes in market conditions.
- It does not consider qualitative aspects like management quality or external factors, including legal or regulatory changes, which may impact a company's bankruptcy.

2. How accurate is the Ohlson O-Score?

The model's accuracy in predicting financial distress or bankruptcy differs based on factors like the collected financial data's quality and the economic environment's stability. Although the model has an accuracy rate of over 90%, it can still produce false signals, as no mathematical model can offer 100% accuracy.

3. What are the factors considered in the Ohlson O-Score?

The model considers several factors, including financial ratios and accounting variables, to assess a company's financial distress and bankruptcy risks. These factors usually include profitability, liquidity, leverage, and other accounting ratios and measures. Each element is assigned a specific weight depending on its relative importance in predicting financial distress.